Implications for income-constrained investors
Charitable investors face a paradoxical challenge: income yields on most of their portfolios have fallen materially since The Global Financial Crisis (“GFC”) in 2007/2008, while capital values have increased significantly.
This trend has been exacerbated during 2020, as central banks and governments have stepped up monetary policy activity to reduce the impact of the COVID-19 pandemic on the global economy, putting further downward pressure on bond yields. In addition, equity investors have experienced dividends cuts as businesses pass on the immediate cashflow impact of the COVID-19 pandemic, and many commercial property investors have taken impairments to rental payments.
The resulting fall in income yields has impacted many UK charities that have income targets for investment portfolios and rely on the expected cashflows to set budgets/spending plans for giving.
In this short article, we examine the potential implications of following an income-constrained approach to investments, as well as exploring how charity investors can address the “income challenge” moving forward.
The table below provides a summary of periodic changes to income yields for each major asset class.
Source: Thomson Reuters Datastream. Data as at 30 September each year. Indices used: UK Government Bonds – FTA UK Fixed Interest Gilts All Stock; UK Investment Grade Credit – Market iBoxx Sterling Non Gilts; Global High Yield Credit – Bloomberg Barclay Global High Yield; Global Equities – MSCI World; Global Equities (“Growth” Stocks) – MSCI World Growth; Global Equities (“Value” Stocks) – MSCI World Value; Global Small Cap – MSCI World Small Cap; UK Property – IPD Property Index.
It is clear that income yields have fallen steadily on major global asset classes over the past 10 years.
An income-constrained investor aiming to deliver an income yield of (say) 4% p.a. now has a reduced investment opportunity set to achieve it in today’s environment. Income-constrained investors may therefore be required to take some (or all) of the following sub-optimal asset allocation decisions on to obtain their desired level of income.
An income-constrained investor would likely need to introduce an equity portfolio bias away from companies/sectors that pay lower levels of income. This could mean smaller or fast-growing companies that reinvest the majority of their profits to fund their growth – importantly, this can include many of the top performing stocks in the US technology sector pay zero or little dividends.
On the other side, income-constrained investors will likely tend to show positive bias towards high dividend paying sectors such as oil & gas, utilities and financials, which do not tend to have the same long-term capital growth potential as other sectors. However, these sectors may have environmental social and governance (“ESG”) characteristics that are not appropriate for the charity.
UK charity investors often have a significant overweight to UK equities within their asset allocations. This may be as UK equities, on aggregate, have traditionally paid higher levels of dividends than many global markets.
However, we would caution against investors taking a significant overweight position to UK equities at this time, due to the associated lack of diversification and potential economic headwinds (e.g. Brexit uncertainty). The UK market is increasingly concentrated in terms of stock exposure and is heavily biased towards certain economically sensitive sectors, such as financials and oil & gas. These sectors also exhibit ESG risks.
As shown in the table on the previous page, the income yield on areas of fixed income with low credit risk (such as government bonds and investment grade credit) has reduced significantly over the past 10 years. This would likely mean that income-constrained investors will need to move up the credit risk spectrum in order to maintain the same level of yield from their fixed income portfolios, which may lead to an increase in default rates and ultimately put capital at risk.
UK charity investors often hold significant allocations to UK property, due in part, to the preferential tax treatment this asset class provides. The asset class has also traditionally offered an attractive income yield. While we recognise the benefits of investing in UK property, on a forward-looking basis, we would caution against a significant allocation – by which we mean more than 10% of total assets - given the illiquidity of the asset class and the economic headwinds associated with a post-Covid-19 world.
Income-constrained investors may also have a reduced ability to invest in alternative asset classes (e.g. hedge funds) that can provide opportunities for attractive capital growth and significant diversification benefits, but do not necessarily deliver predictable levels of income.
How can charity investors address the income challenge?
Many income-constrained charity investors have already been forced to review and adjust spending plans during 2020 due to the impact of Covid-19 on their investment portfolios. While we expect equity dividends and property rent impairments to revert by the end of 2021 (at least partially), we believe the broader “income challenge” caused by suppressed bond yields is here to stay. Below we outline two potential ways for charity investors to address this problem moving forward:
1) Consider investing in non-traditional income-producing asset classes
As highlighted in the previous section of this article, traditional asset classes have experienced significant downward pressure on income yields in recent years.
In particular, high dividend paying, publicly listed companies are becoming increasingly concentrated by sector and geography, thereby limiting the opportunity set for income-constrained investors. In addition, within fixed income, investors are being required to move further up the credit spectrum to chase additional yield. These two dynamics could increase the underlying capital risk of investor portfolios.
In order to mitigate these risks, we recommend that income-constrained investors wishing to increase yield consider introducing alternative approaches, such as “multi-asset credit” and some areas of private markets. We provide more details on these two asset classes below.
Multi-Asset Credit (“MAC”) funds offer an alternative approach to investing in growth fixed income. In particular, they rely heavily on manager skill to allocate across a range of typically higher yielding credit instruments, such as emerging market, high yield and securitised debt, and loans.
The key benefit is that these managers aim to deliver a high level of income (>5%) with reduced levels of credit and interest rate risk compared to investing directly in high yield bonds.
Given the reliance on active management skill, effective manager selection is important in this asset class. Mercer has a significant amount of experience in selecting and building client solutions in this area.
Private debt investments were once the purview of banks, but regulatory change in the aftermath of the GFC forced banks to scale back their lending. Consequently, a wide range of opportunities became available to institutional investors in the subsequent years – many of which have strong income producing potential.
More broadly, other private market investments have become more widely available as funds and strategies have been developed in this space.
In particular, asset classes such as unlisted infrastructure, renewable energy, real estate debt, and private debt can offer attractive income yields to investors, often with the same or lower level of associated credit risk than public markets.
However, investing in private markets means accepting lower liquidity and higher complexity. It is therefore important for clients to consider allocating to these areas in the context of their overall circumstances. Mercer has a great deal of experience in supporting clients in structuring private market portfolios to meet their needs and effectively mitigate these challenges.
2) Adopt a “total return” approach
We work with an increasing number of charity clients who have adopted a “total return” approach for their investments. This means they have removed a specific income target and instead aim to deliver an overall return through both capital and income sources.
In 2013, the Charity Commission introduced new guidance that permitted permanently endowed charities (i.e. those whose rules allow them to spend only income) to adopt a total return investment strategy without seeking its approval.
As highlighted in this article, a total return approach can allow trustees to invest in lower-yielding assets that may better suit their objectives. It is worth noting that a total return approach does not force charities into lower-yielding assets, rather, it opens the door to a wider universe of assets from which to build their portfolio.
Disclaimer: Investors considering moving to a total return approach should consult independent legal advice.
3) Revisit the spending rule
As income yields fall and look likely to remain low for the foreseeable future, it might be a good time to revisit the charity’s spending formula. For example, if spending capacity is calculated through a formula based on historic income received, it might be beneficial to reweight it.
Mercer have significant experience in assisting with such projects and would be happy to help you take your first steps to reassessment.
Income yields on most charitable investor portfolios have fallen materially since the GFC as capital values have increased significantly. Income-constrained investors, including many UK charities, may therefore feel they need to take sub-optimal asset allocation decisions on their investments to obtain their desired level of income.
In this article we have highlighted ways in which charity investors can address this problem – including the introduction of new income producing asset classes (such as MAC and private markets) and/or moving to a total return approach for investing.
At Mercer, we have a great deal of experience in helping our charity clients navigate these issues. Please contact us to find out more.
1 FTSE All Share has averaged 1.6% higher dividend yield compared to the MSCI AC World (ex UK) Index over the past 5 years.
2 As at 30/9/2020 the top 10 stocks in the FTSE All Share Index make up >40% of the market cap.
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